Jeremy Grantham’s Solution to the ‘Overvalued’ U.S. Stock Market

Jeremy Grantham believes the U.S. stock market is egregiously overvalued.  

The S&P 500’s cyclically-adjusted price-to-earnings ratio—better known as the CAPE ratio—is trading around 33, the highest level ever outside of the dot-com bubble and 2021.  

“Starting with very high prices is a pretty much guarantee that for the next 10 or 15 years, you will be disappointed,” Grantham told a packed audience at the Exchange conference in Miami Beach, Florida. 

Grantham is the co-founder and long-term investment strategist at GMO, which launched its first exchange-traded fund three months ago—the GMO U.S. Quality ETF (QLTY). 

In his view, QLTY, which already has $260 million in assets under management, is the solution to the overvaluation of the U.S. stock market.  

“Emerging markets are pretty cheap and Japan is very interesting; it’s the U.S. that’s [expensive]” Grantham said.  

But investors still have to put money to work in U.S. stocks, which raises the question of what to do with that money. According to Grantham, quality is the answer.  

“Quality is the longest market inefficiency in history. For 100 years, the AAA stock has yielded an extra half a percent. The AAA bond, we all know, costs you one point because it’s high quality and doesn’t go bust as much. AAA stocks don’t go bust as much either— they do better in bear markets— and yet they have returned on average an extra half a point,” Grantham explained. 
 
Quality tends to underperform during bull markets, but they “always win” in bear markets, Grantham noted. 

Why Quality Stocks Outperform  

GMO defines quality stocks as those with “established track records of historical profitability and strong fundamentals,” while iShares, which manages the biggest fund in the category, the $35 billion iShares MSCI USA Quality Factor ETF (QUAL), defines quality stocks as those with “high ROE, stable earnings growth and low debt/equity, relative to peers.” 

But if quality stocks have such great fundamentals, why do they perform so well? You would think that investors know about their superior fundamentals and would bid them up to a level where any excess returns would be quickly erased.  
 
Grantham says that this doesn’t happen because during bull markets, most investors want to buy the “sexiest stocks [they] can find, and quality—the Procter & Gambles of the world are boring, so [they] skip them.” 
 
Because of that, “they end up outperforming with their high returns and big dividends.” 
 
It's an interesting theory and one that Grantham hopes will resonate with the investors who tuned in for his talk this week. 

In addition to touting quality, Grantham had good things to say about resource and climate change-focused stocks.  

He also made the case that value stocks were “unusually depressed” relative to growth stocks, and that he expects the gap between the two to eventually narrow.